Investor Education—Legitimate Investing Risks Compared to Fraud Risk-Understand the Difference
A promissory note is a form of debt; it is similar to a loan or an IOU. A person or company needing money may issue a promissory note to an investor in exchange for money. The investor agrees to loan money to the person or company for a set period of time, at a specified rate of interest, with set repayment terms and conditions spelled out in the note document.
Investors seek safe, fixed-rate investments, that promise to deliver interest rates that appeal to them.
In today’s low interest rate environment finding appealing interest rate investments is a challenge; banks and credit unions now pay from.50% to 1.50% annually; we are in the lowest interest rate period of modern times.
To increase the interest rate requires taking on more risk. Remember, there always is a direct correlation between the risk assumed and the reward received. Every investment involves some degree of risk, and the highest-yielding investments usually carry the highest levels of risk. A high yield is an investing red flag. It warns the investor to stop and carefully evaluate the investment to understand why the yield is high and what are the risks being assumed. Above market returns suggest higher risks.
Every investing situation is different. No “one-size-fits-all” rule exists that explains what causes risk and how much risk exists. The best way to gain understanding of a specific investing situation is to ask tough questions. Demand clear, direct understandable answers – before moving forward with an investment. An investing decision to buy or make a promissory note investment should be based on solid facts and clear understanding. Be sure you understand how the investment will be repaid, and how the periodic payments will be made; learn where and what the potential problems and risks are. Understanding is the key to safe investing.
Types of Risk
Risk Free—Many con artists will try to sell a risk-free return. In reality, nothing is risk-free and this should be kept in mind when someone is telling you otherwise. If someone is pitching the idea that a promissory note investment is a “risk-free” with a large potential return, the warning bells should ring! Watch out for promissory notes that are supposedly “insured” or “guaranteed. That story is probably too good to be true; be skeptical that it is a legitimate investment. Beware of promises of “risk free” returns. These claims are the bait con artists use to lure in their victims. Always remember that if it sounds too good to be true, it probably is untrue.
The borrower may have honorable repayment intention and still cannot keep the repayment promise. Adverse business conditions, new laws, new inventions, new competitors, changing customer habits, and personal health issues are some of the inherent risks related to the repayment of borrowed funds.
Interest Rate Risk
Interest rates constantly change. The changes are driven by government policy and the supply and demand for money in the market place. The risk always exists that a fixed-rate promissory note will be out of sync with market rates in the future. This will impact its resale value.
The market for investing in notes constantly changes due to local and national business conditions, supply and demand for investments, available cash in the market place, and investor’s view of future events.
Historically, over the life of this country, we have had inflation. Inflation devalues fixed rate investments. Inflation reduces the purchasing power of the dollar. A dollar repaid in the future will not have the same purchasing power as it had when the investment was made. The longer the term of the promissory note the greater the risk of lost purchasing power of the dollar.
Risk is an inherent part of investing. Since risk cannot be avoided when investing, investor education is critical to success. Risk management and risk recognition are the foundation of long-term investing success.